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Part 2. Cost-Value-Profit and Business Scalability

6. Cost Behavior

"Profitability is just around the corner." This is a common expression in the business world; you may have heard or said this yourself. But, the reality is that many businesses don't make it! Business is tough, profits are illusive, and competition has a habit of moving into areas where profits are available. And, sometimes, business owners become frustrated because revenue growth only seems to bring on waves of additional expenses, even to the point of going backwards.

How does one realistically assess the viability of a business? This is perhaps the most critical business assessment a manager must make. Most of us are taught from an early age to do our best and not give up, even in the face of adversity. And, there are countless stories of businesses that struggled to survive their infancy, but went on to become highly successful firms. But, it is equally important to note that some business models will not work. You likely have heard the tongue-in-cheek story about the car dealer who said he loses money on every sale but makes it up on volume. Of course, the math just won't work. A good manager must learn to use information to make informed decisions about which business prospects to pursue. Managerial accounting methods provide techniques for evaluating the viability and ability to grow or "scale" a business. These techniques are called cost-volume-profit analysis (CVP).

6.1. The Nature of Costs

Before one can begin to understand how a business is going to perform over time and with shifts in volume, it is imperative to first consider the cost structure of the business. This requires drilling down into the specific types of costs that are to be incurred and trying to understand their unique attributes.

6.2. Variable Costs

Variable costs will vary in direct proportion to changes in the level of an activity. For example, direct material, direct labor, sales commissions, fuel cost for a trucking company, and so on, may be expected to increase with each additional unit of output.

Assume that Go Sound produces portable digital music players. Each unit produced requires a printed circuit board (PCB) that costs $11. Below is a spreadsheet that reveals rising PCB costs with increases in unit production. For example, $1,650,000 is spent when 150,000 units are produced (150,000 X $11 = $1,650,000). The data are plotted on the graphs. The top graph reveals that total variable cost increases in a linear fashion as total production rises. The slope of the line is constant. Of course, when plotted on a "per unit" basis (the bottom graph), the variable cost is constant at $11 per unit. Increases in volume do not change the per unit cost. In summary, every additional unit produced brings another incremental unit of variable cost.

Variable Costs

The activity base is the item or event that causes the incurrence of a variable cost. It is easy to think of the activity base in terms of units produced, but it can be more than that. Activity can relate to labor hours worked, units sold, customers processed, or other such "cost drivers." For instance, a dentist uses a new pair of disposable gloves for each patient seen, no matter how many teeth are being filled. Therefore, disposable gloves are variable and key on patient count. But, the material used for fillings is a variable that is tied to the number of decayed teeth that are repaired. Some patients have none, some have one, and others have many. So, each variable cost must be considered independently and with careful attention to what activity drives the cost.

 
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